from Follow the Money

Skating on incredibly thin ice

April 11, 2005

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Altogether, the circumstances seem to be as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

-- Paul Volcker, Former Chairman of the Federal Reserve, Washington Post

I’ve been involved in economic issues for a long time, and I think this may be the most critical juncture for our economy in my lifetime. And while the outlook is always complex and uncertain, I think this is the most complex and uncertain [outlook] in some number of decades.

-- Robert Rubin, Former Treasury Secretary, address to the Stern School on October 14, 2004.

That is Rubin-speak for "I am very worried, and you should be too."

Doubt my translation? Look at what Rubin said two weeks ago in North Carolina. He used the word "disaster" and "fiscal and current account deficits" in the same sentence.

And, as Mark Thoma of the Economists’ view has highlighted, at least one member of the Federal Reserve’s Open Market Committee is a bit more worried by current global imbalances than Ben Bernanke.

Why the concern?

US fiscal deficit is quite large in good times, particularly in relation to (almost non-existent) US household savings, leaving no buffer against bad times. Counter-cyclical fiscal policy is a lot harder when you start off with a 3.5% of GDP deficit than when you start off with a fiscal surplus.

And the US is heading towards a current account deficit of 7% of GDP this year, unless something changes. That is enormous in relation to the United States’ export base (10% of GDP. It indicates an equally enormous reliance on foreign savings. As the Economist has noted, net US savings is only 2% of GDP -- not enough to finance current levels of US net investment.

A large current account deficit is often an indicator of strong current growth. But it also is a leading indicator of potential future trouble.

Mexico’s current account deficit in 1994, the year of its crisis: Around 7% of GDP.

Thailand’s current account deficit in 1996, the year before its crisis: Around 7% of GDP.

There are enormous differences between the US and Mexico and Thailand. The US looks like an emerging economy in some respects --political paralysis in the face of growing debt problems, for one -- but not in others. No emerging economy can finance itself by selling debt -- oops, worthless IOUs -- denominated in its own currency at low fixed rates, for relatively long-terms.

The sheer size of the US almost guarantees that any current account adjustment in the US will certainly play out differently than past current account adjustments. I certainly hope it will not resemble the "current account adjustment" (more commonly called a financial crisis and a sharp recession) many emerging economies experienced. But it quite possibly also will play out differently from past current account adjustments in other advanced economies.

We really don’t know: never before has such a large economy run such a large current account deficit. The ice is thin in another way too. Let’s just say the term "geopolitical risk" now increasingly applies to East Asia as well as the Middle East.

The biggest single source of new financing for the US right now is the government of (communist) China, which is single-handely providing about a quarter of the external financing we need. That is a change from early last year, when the government of (democratic) Japan was our biggest ongoing buyer of US debt. Yet even as our financial dependence on China has grown, our overall relationship with China seems to have soured.

The Chinese leadership has been the paragon of financial responsbility, and it has never even hinted (to my knowledge) that they might want to diversify their reserves -- unlike US allies Japan and Korea. Their reward: the US successfully campaigns for Europe to keep its arms embargo on China in place.

Kash at the Angry Bear highlights how China could use its $650 billion plus in reserves -- and roughly $500 billion in dollar reserves -- to put a little financial heat on the US. I would note that China will retain the threat to sell its existing assets long after it stops adding to its new assets. China does not even need to play its financial card overtly for US policy to be influenced by the possibility of a massive Chinese sell order ... Some folks on Wall Street are likely to do China’s dirty work for it if tensions between the US and China ever really heat up ... The smart money on Wall Street wants to be the first, not the last, to sell.

Tom Schelling taught us that threats -- including the threat to sell -- are costly when they fail. China would lose financially if it "sold" (though, these are just paper losses ... at least according to some). And no doubt the collapse of the balance of financial terror would influence the flow of goods across the Pacific, in ways that hurt China -- and Wal-Mart alike. At the same time, China clearly would not finance a US defense build-up intended to ... contain China.

The relationship between the US and China is not the only game in town either.

Three of the United States four biggest creditors (or all four, from the point of view of the Chinese government, since China no doubt believes it speaks for Taiwan as well ... ) are getting together to discussion financial cooperation later this month. They, however, no doubt, watch each other just as closely as they watch the US.

Yet even as China and Japan talk of deepening their financial cooperation, their broader relationship is facing just a few strains.

And then there is India, whose central bank is a rising financial power in its own right. A fast-growing India will compete with China, and the US, for access to the world’s remaining oil. And while Japan seems to be cozying up to the United States in the face of a rising China, India presumably does not want to be forced to pick sides should the US ever conclude that China really does need to be contained ...

Bob Zoellick and his Chinese counterpart would have plenty to talk about even if China’s rising global trade surplus was not making it ever more difficult to diffuse growing protectionist pressure in the US.

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